Monday, September 22, 2008

Socialism and the Banking System

In one recent post, I came close to advocating the overthrow of the capitalist system. Well, not exactly. But I did suggest that a policy which, at the time, I described as “socialist,” or at least a credible threat of implementing such a policy, might be necessary in order to solve the financial crisis in a way that is fair to taxpayers. At the time I hadn’t thought through, on a theoretical level, why such a policy might be necessary. In the context of a later post, I filled in the theoretical details, and I have since realized that the “socialist” policy is not inherently socialist at all, and if properly implemented, it can be defended as a normal part of capitalism.

Essentially, the policy, as I now imagine it, involves having the government act as an agent for creditors “before the fact” of a default. It is, of course, quite common for the government to act as an agent for creditors after the fact. When somebody refuses to pay his debt to you, you don’t go over to his house with a shotgun; you take him to court and let the government force him to pay. But creditors have issues before the fact as well. If debtors have limited liability, they have an incentive to take excessive risks with creditors’ money. Sometimes creditors are in a position to prevent debtors from taking those risks, but sometimes they are not – for example, when the creditors are widely distributed and cannot effectively police the debtors. In those cases, it makes sense for the government to take on the policing role.

The specific issue is whether undercapitalized banks have an incentive to hold on to securities and overvalue them on their balance sheets rather than accept an offer to buy them at fair value. (I’m talking about securities that are very hard to value, so here uncertainty acts like a smoke screen. Nobody can say for sure that the securities are overvalued on the balance sheet. Nobody can say for sure whether the offer to buy was at fair value. Even producing a rough estimate of the value is quite difficult. This allows banks to get away with intentionally overestimating the value, since a creditor of the bank would require substantial resources to determine whether the bank is overvaluing the assets or not, and even then the creditor wouldn’t be able to prove it.)

From the bank’s point of view, there is no difference whether its equity goes into the red or just goes to zero. Therefore, if the fair value of the bank’s equity is already near zero, the bank has nothing to lose by taking excessive risks that could result in increasing the fair value of its equity. The particular excessive risk I have in mind is holding on to an illiquid asset rather than selling it at fair value. If the fair value of the asset goes down, the fair value of the bank’s equity will go negative, the bank will eventually fail, and its creditors will lose money, but the bank’s owners will be no worse off, since the fair value of their capital was zero to begin with. If the fair value of the asset goes up, of course, the owners will be better off, but the creditors will be no better off than they were before.

[EDIT: Note that this same moral hazard exists, to a lesser extent, even when the bank has adequate capital. It may still be in the bank's interest to gamble on recovering more of an asset's original value -- which will flow directly to the bottom line without enriching creditors -- rather than selling it at the current fair value. Usually holding on to the asset will be against the interest of creditors, since the bank has adequate capital already and there is no reason for creditors to want to take risks with that capital [EDIT2: except for the normal, presumably much smaller, risk that the bank takes in the course of its ordinary business, which is necessary so that it can earn enough to pay the interest due to creditors].]

Somehow, the creditors should have a way to force the bank to sell its illiquid asset if it gets a fair bid. Moreover, in a reverse auction, such as is proposed as a way to implement the Paulson Plan, the creditors (and the taxpayers) should have a way to force the bank to bid fair value rather than some higher value. Unfortunately, these are very difficult things to do, because, as discussed earlier, the asset is very hard to value. The only practical way to do it is for the government (or some neutral party) to estimate fair value and then force the bank to sell at that price. (Note: If all banks are behaving in the interest of their creditors, then each one will bid fair value, or near it, in a reverse auction, because the primary interest of the creditors is to win the auction But it doesn’t work if only one bank is doing so and knows that the others are not, because that bank will realize that it can win the auction even by bidding above fair value.)

For a commercial bank, the real creditor is usually the FDIC. The FDIC should have the right to force banks to accept fair value for their illiquid assets, and it doesn’t make much difference if the valuation is done by the FDIC or the Treasury or, for that matter, some other party. And it also doesn’t make much difference who enforces the required sale – it could be the FDIC, or it could be the Treasury acting as an agent for the FDIC.

Of course the resulting reappraisals may be quite agonizing. Some banks that were believed to be adequately capitalized will turn out not to be. They will have to either raise capital in the private sector (possibly by allowing themselves to be bought out) or make a deal with the government whereby the government gives them an infusion of capital in exchange for equity participation (which, after all, is essentially what would normally happen if they raised capital in the private sector).

In some cases banks that were believed to be solvent will turn out to be insolvent. They must be either liquidated or taken over (by another private sector entity or by the government). It might be reasonable to use public funds to reduce their liabilities so that some other institution would be willing to take them over. In the case of commercial banks with insured deposits, the public will end up getting the bill anyhow, so why not do it in a way that is less disruptive and allows the bank to continue operations?

So there you have it: the Knzn plan. I think Maynard would approve. It involves coercion, and in some cases takeover, of private entities by the government, but it’s not really socialist, because that coercion is ultimately on behalf of other private entities with legitimate interests that they are unable to defend. As a side effect of defending those private interests, the public gets a fair deal.

UPDATE: In a comment, Johnchx points out that the existing regulatory mechanism can (and, if it's functioning properly, will) force banks to write down assets to fair value. What the existing mechanism can't do, though (as far as I know), is to force a bank that is adequately capitalized, but just barely so, to sell its illiquid assets if it receives a fair offer. In many cases, such banks will have an incentive to reject offers at book value, when the asset is fairly valued on the books. (See my edit above.)

UPDATE2: In any case, that regulatory mechanism only works for commercial banks. Investment banks are possibly a bigger problem (largely because there is no insurance to prevent "runs").

UPDATE3: In my plan, paradoxically, the creditors, whose interests are being defended in each specific case, end up with a worse deal (at least if the Treasury promises to buy at the reverse auction price). The moral hazard of the bankers essentially allows the creditors to behave like a cartel and extract monopoly profits -- in the form of greater security due to having larger capital cushions -- from the Treasury. But we do have antitrust laws and such to prevent anti-competitive behavior, so it makes sense to enforce fair competition among banks selling securities to the Treasury. It's still not socialism.

75 Comments:

johnchx said...

But doesn't the Comptroller of the Currency (and/or the OTS) already have -- in effect -- the power you want to grant to the FDIC? While the bank regulators can't force a bank to actually take an offer they deem fair, they can force the bank to update its balance sheet as if it had -- i.e. to write down the book value of risky assets to a level the regulators deem "fair." And if a bank gets anywhere near "zero equity," they shutter the bank and hand the whole mess over to the FDIC.

I suppose that aggressive pursuit of the existing regulatory mechanism might be sufficient. The problem up to now, though, I think, is that, given that the securities are so hard to value, regulators have not been as aggressive as they might be in forcing write-downs. Also, even to the extent that they have tried to be aggressive, I wonder if the write-downs have adequately accounted for the risk premium.

One thing that may be necessary is to have a set of structures that makes it less traumatic to the overall system when a bank fails due to undercapitalization. I suspect that regulators are cautious about forcing write-downs that will reduce a bank's book capital too low, out of fear of the systemic effects of too many bank failures.

I also suspect that too few resources have gone into the project of trying to find a fair value for various bank assets and that the resources have not been used most effectively. The process would probably be more efficient and effective if it became a grand project rather than a case-by-case analysis. (If you determine the value of a certain tranche, for example, then that can be applied to anyone who owns the tranche. And it's easier to determine the value of one tranche if you've already started to value another tranche from the same deal. I'm not sure to what extent regulators currently take advantage of those efficiencies.)

Another thing that would be important is for regulators to thoroughly examine (and aggressively write down when appropriate) a bank's assets before that bank is allowed to bid on purchases by the proposed Treasury fund. But in that case, why bother with the reverse auction? Why not just let regulators determine the fair value and then offer to buy at that book value?

Now that I think about it, though, even banks that have enough capital to avoid being shut down would still have an incentive to take excessive risks, and one such risk might still be to reject a fair offer for illiquid assets, even if that offer were at book value or slightly higher. So it might still be necessary to force banks to sell.

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